Why markets may need the FAANGs to show more bite and the BATs to fly again

Flying bats image

There is an old market rule which says that when the individual stocks or sectors that took the broader market indices higher start to tire and roll over then everyone needs to be careful.

And it is an old market rule because it has stood the test of time.

For example, see how the NASDAQ Composite index rolled over before the broader US stock indices did, just as the bursting of the technology, media and telecoms bubble sowed the seeds of a wider equity market downturn in early 2000. A three-year bear market ensued in the USA (and the UK, Europe and Asia, for that matter).

NASDAQ’s loss of momentum in early 2000 heralded wider market problems as tech bubble burst

Source: Thomson Reuters Datastream

During 2003 to 2007 it was financial stocks, and particularly banks, that made the running. Lo and behold they peaked in 2006, as someone, somewhere sensed that too much money was being loaned in too free-and-easy a way and that rising interest rates would make things a lot more difficult for borrowers and lenders alike. Global stock indices hit the wall in mid-2007 and a brutal 21-month market slump followed.

Roll-over in previously market-leading financials stocks warned in 2007 of trouble ahead

Source: Thomson Reuters Datastream

It requires little imagination to guess which stocks have been taking global benchmark indices higher this time (not least because they feature in so many passive funds that follow their own, smart beta, or customised index) – the FAANG stocks in America (Facebook, Apple, Amazon, Netflix and Google’s parent, Alphabet) and their Asian cousins, the BATs (Baidu, Alibaba and Tencent).

Advisers and clients with aggressive equity allocations may therefore be hoping, in the short term at least, that the FAANGs regain some bite and the BATs take flight again. Both groupings have begun to flag.

FAANG stocks have begun to show some weakness

Source: Thomson Reuters Datastream

… as have the Chinese internet wonders, the BATs

Source: Thomson Reuters Datastream

Action replay

These are trends which must be followed closely in the coming weeks and months, to determine whether it is just part of the summer silly season or a real trend that could have serious implications for clients’ and advisers’ portfolios.

We already have one potential clue. The S&P 500 growth stocks index started to underperform the S&P 500 value stocks late in the second quarter, a marked break from anything we have seen for several years (with the exception of 2016).

Value has just started to outperform growth again

Source: Thomson Reuters Datastream

The past is not guaranteed to repeat itself and such a switch does not necessarily herald the end of the bull market but at the very least it may mean that clients and advisers may need to consider how much risk they are taking, if they have substantial exposure to growth and momentum plays via their preferred active and passive funds.

At first glance it can be argued this has limited implications for UK stocks. Technology Hardware may be the fourth-best performer among the 39 industrial groupings which comprise the FTSE All-Share, but Software & Computer Services is the worst (thanks to FTSE 100 member Micro Focus) and between them they are tiny, representing just 1% of the index’s market capitalisation.

Cyclical or secular

However, improved performance from value relative to growth could have implications for fund selection.

It is noticeable how value-oriented funds, such as Jupiter UK Special Situations for example, have shown improved performance of late (and indeed have done so since the UK ten-year Gilt yield bottomed some time ago).

Value-oriented funds are also showing signs of (out)performance

Source: Thomson Reuters Datastream

Perhaps this lies at the heart of the ‘value versus growth’ debate. Gilt yields may well take their lead from central bank interest rate decisions, with the following implications:

  • If the Bank of England is tightening policy because the economy is doing well and inflation is accelerating, then in theory corporate profits growth should be robust. There is therefore less reason to pay very high valuations to get access to the secular growth offered by sectors such as tech and biotech if a rapid cyclical upturn in company earnings is underway.
  • Many momentum and growth stocks are priced off the earnings that they are expected to generate some way off into the future. These profits are often valued according to a discounted cash flow model, or DCF, which applies a discount (or interest) rate to those earnings and discounts them back to get a value for them in today’s money. The higher interest rates go, the higher the discount rate and the lower the value of those future earnings today – something which could affect tech stock valuations, for example.

Gilt yields (and unwittingly the Bank of England) may have a big say in the ‘value versus growth’ debate and therefore the direction of stock markets overall, if the change in stock leadership becomes a trend, with all of the historical implications this has for headline indices.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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